Warranty Policy and Extended Service Contracts: Theory and Application to Automobiles

This paper characterizes the manufacturer warranty policy and its effect on consumer behavior under the following conditions: consumers are heterogeneous in risk preferences, consumer actions affecting the probability of warranty redemption are unobservable to the manufacturer, and the product reliability is known. We obtain the precise ‘menu” of warranty contracts, and then make connections with its institutional counterpart: the extended service contract._x000B_ The model’s implications for consumer behavior are examined using data obtained from a sample of recent buyers of new cars. The role of risk in consumer behavior with respect to choice of extended service contracts, and the allocation of effort for maintenance are found to be consistent with the model’s predictions._x000B_ From a managerial perspective, our empirical analysis permits quantifying the demand for extended service contracts as a function of the extent of manufacturer warranty. We show that for our sample of buyers a manufacturer warranty of 3 years is optimal in the sense of overcoming the role of risk aversion in the choice of extended service contracts._x000B_